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Duke Economics Working Paper #04-05

Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending


Árpád Ábrahám (Duke University) and Nicola Pavoni (University College London and Institute of Fiscal Studies)

Abstract

We analyze a dynamic moral hazard setting, in which agents can borrow and lend and their decisions about effort, consumption and savings are private information. In contrast with previous findings, we show that as long as agents do not have perfect control over publicly observable outcomes, the efficient allocation is welfare improving with respect to the case where the agents can self insure only through borrowing and lending. We identify the main sources of welfare improvement, and we compute substantial efficiency gains. We provide a tractable recursive framework to study the optimal allocation in this setting. The dynamic programming formulation is based on a generalized first order approach, whose validity is verified ex post, using a parsimonious numerical procedure based on the recursive formulation itself.

Keywords:
Moral hazard, hidden savings, social insurance, first order approach, recursive contracts, ex-post verification.

JEL Classification: C61, D82, E21, H21.

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69 pages

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